ETFs Help Remove Fear From Bond Market Investing

During his 1933 inaugural address, Presidential Franklin D. Roosevelt uttered the now famous words, “The only thing we have to fear is fear itself.” With the U.S. economy deep in depression, FDR’s message to the public was to calm down and adapt rationally to the changing times. Fear would only make things worse.

More than eight decades later, in today’s financial markets the demon du jour is the threat of rising interest rates and the perceived devastating effect this will have on bond investment portfolios. There has been a considerable amount of fear being spread by financial pundits and the press, with headlines about bond “massacres,” “crashes,” and “panics.”

In considering the consequences of rising interest rates, a version of FDR’s plea for calm reasoning and some factual perspective must be considered to counter overly emotional interest rate fears.

Let’s start with some basics. First, an expected rise in interest rates and/or increased inflation are legitimate concerns. However, in the latter case, it appears that a modest increase, which seems most likely after years of below average rates of inflation, would be welcome to many, including income-oriented investors. Further, the negative effect on bond valuations will be more negatively impactful to prices of long term bonds (more than 10 years to maturity) than those with shorter maturities.

Fixed-income investors willing to sacrifice some current income for the peace of mind associated with shorter-term maturities might look to iShares Short Maturity ETF (NEAR) or the SPDR BarclaysBarclays Intermediate Term Corporate Bond ETF (ITR).

Fixed income-based ETFs are also available that invest in floating rate securities where the payments increase when benchmark interest rates rise. Two examples are the IShares Floating Rate Bond ETF (FLOT) and the more risky, but higher yielding, PowerShares Senior Loan Portfolio (BKLN). (We own both at Efficient Market Advisors.)

Second, consistently predicting the future course of interest rates is mission impossible. No one knows when, how much, or how fast rates will rise. While rising rates cause bond prices to fall, historically the damage to bond portfolio values is generally limited to single digits as opposed to serious double digit drops for stock portfolios. Even in down markets for bonds, these securities have defensive advantages for an investment portfolio.

Consider the meteoric rise in interest rates from the late 1970s through the early 1980s. During this period the yield on the 10-year US Treasury topped 15.5% in October of 1981. Nonetheless, the Barclays US Aggregate Bond Index delivered small but positive returns in of 3.04% (1977), 1.39% (1978), 1.93% (1979), 2.71% (1980), 6.25% (1981). The index had its worst ever year (-2.92%) in 1994.

For broad bond market ETF-holding investors, the loss of bond value may be transitory as a portfolio of lower yielding holdings is replaced with bonds carrying higher yields. In this scenario, the patient bond investor stays with the broad based index ETF such as the Vanguard TotalTotal Bond Market ETF (BND) to capture increasingly competitive rates of return.

To be fair, one must also consider the potential effects of inflation on the purchasing power of a bond portfolio. After all, it wasn’t the bond market that tore apart an investor’s purchasing power in the late 1970s; rather it was inflation.

Congress responded to the inflation threat through the Humphrey Hawkins Full Employment Act in 1978. Since that time, the U.S. has not experienced significant consumer inflation. Perhaps the bond market itself is telling us not to be overly concerned. Bond exposure through ETFs represents a sound asset-allocation decision that will reduce the risk of equities and provide balance to an overall portfolio. And, in an increasing interest-rate raising environment, investors can expect to receive improved yields.

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